Look Beyond ETF Fee To What's Inside

In less than two weeks, many within the ETF industry will travel to Florida for the Inside ETFs conference for education and networking.

CFRA will help kick off the ETF University track for advisors on Sunday, Jan. 26. Here’s how the agenda describes our session: “As ETFs have grown in popularity, so has their complexity. Making sense of it all can feel overwhelming.”

Below we highlight a few case studies we plan to review with conference attendees as a reminder that what’s inside an ETF is important to CFRA and investors alike.

The “easy button” with ETFs involves buying the cheapest ETF within an investment style, believing all are the same, or choosing the better performer in a period, presuming that the performance success will repeat. Unfortunately, with most index-based ETFs tracking unique benchmarks, the easy route will result in disappointment.

Other meaningful subindustries include building products (14% of assets), such as Masco Corporation (MAS), and home improvement retail (10%) companies like Home Depot (HD). ITB charges a 0.42% expense ratio and trades 3 million shares daily.

Investors might be surprised that a fund with homebuilders in its name had just 32% of assets in that particular subindustry. Indeed, XHB had more exposure to building products, 33% of assets, with MAS (4.6% of assets) representing a larger position than DHI (4.3%).

The performance differential between XHB and ITB has recurred in the past due to the exposure differences, with XHB losing less in 2018 (-26%) than ITB (-31%), but underperforming in 2017 (32% vs. 60%).

Digging Into Fixed Income

In rating ETFs, CFRA cautions investors from relying too much on past performance, focusing more on the valuation and risk consideration of the fund holdings. Our focus on more than past performance applies to bond ETFs, too, though the metrics we think matter—including yield and duration—are different.

In 2019, investors were rewarded for taking on interest rate risk, with the Federal Reserve cutting rates multiple times and funds that invested in long-term securities rising sharply. The iShares 20+ Year Treasury Bond ETF (TLT) was a big beneficiary, as the fund gathered approximately $7.5 billion of new money per First Bridge Data, a CFRA company.

TLT rose 14% in 2019, ahead of the popular Bloomberg Barclays Aggregate Index’s 8.5%. TLT’s average duration—a measure of interest-rate sensitivity—was 18 years, a level much higher than the broader bond index’s average of six years. TLT’s net expense ratio is a modest 0.15%.

In contrast, the PIMCO 25+ Year Zero Coupon US Treasury Index ETF (ZROZ) charges a similar 0.15% expense ratio, but rose an even stronger 21% in 2019. Despite the outperformance of TLT and the broader bond category, ZROZ gathered less than $100 million of net inflows last year.

The PIMCO fund tracks an index of just the final principal payment of long-maturity U.S. Treasury bonds. The fund’s average duration of 27 years positioned it well to benefit in 2019 from falling interest rates. However, in 2018, ZROZ’s 4.6% decline was wider than TLT’s 1.6% loss, a reminder that past performance success can be fleeting.

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